FX Hasn’t Yet Priced in Risk of U.S. Default

By Vincent Cignarella

Ever since late October, fixed-income investors have prudently taken a cautious view of the fractious budget negotiations in the U.S. Congress. The same can’t be said for currency traders.

Over this time, investors have bid up the price of protection against a U.S. sovereign default–continuing through the year-end fiscal cliff debate and into the current prelude to a debt-ceiling standoff in February–while currency traders have gone the other way, buying currencies that should fall if the deadlock deepens.

With recent history as a gauge, that suggests we could soon see a big buying opportunity for the dollar.

U.S. credit-default swaps, which set the price for insurance against the U.S. missing payments on its debt, have risen 46% since Oct. 30. First, the concern was focused on the Jan. 1 fiscal-cliff deadline. Now it is on the second round of negotiations lawmakers put in place in a compromise deal at that time, an agreement that set up the looming debt-ceiling threshold and a set of sweeping automatic spending cuts known as the “sequester” as twin flashpoints for the end of February.

That move has taken the CDS market toward its highs from July 2011, the last time a Republican-led House used the threat of not increasing the debt ceiling to try to negotiate a pledge from President Barack Obama to cut spending.

Now we are back in the same situation. With the U.S. projected to hit the ceiling in mid-February, President Obama is insisting Congress approve an increase in that limit unconditionally while House Speaker John Boehner (R., Ohio) is tying any increase to demands for spending cuts. This impasse is raising the probability the U.S. will reach a point at which it can’t legally obtain the funds needed to make debt repayments. In other words, it will do the once-unimaginable: it will default.

Such an event would trigger a huge “risk-off” trade, sending the euro tumbling and investors flying back into the Japanese yen and the Swiss franc in search of safety, completely reversing the recent trend.

Yet foreign-exchange markets appear to be ignoring the risk. Even as swap spreads have increased and interest rates have risen, the FX market is effectively assuming zero risk premia for this scenario.

This might reflect a conundrum in currency investing today: as the U.S. heads into a crisis of this nature, investors usually buy dollars rather than sell them, even though the U.S. itself is at the center of that crisis. Yet of late the bias has been to sell dollars, at least versus the euro, as investors become more comfortable with stabilization in the euro-zone debt crisis and with the idea monetary policy in Europe will remain tighter than in the U.S.

Currency-market participants might instead want to review what happened in July 2011, when the previous debt-ceiling fight got down to the wire. Back then, the euro tumbled from a high of $1.4580 to a low of $1.3838 as budget talks stalemated and CDS spreads climbed to a high of 64.36 basis points from a low of 49.985.

Contrast that with what has happened so far this month: CDS spreads have widened from a low of 37.66 basis points Jan. 1 to a high of 44.00 on Friday, yet the euro has traveled from a low of $1.2998 Jan. 4 to a high of $1.3404 Monday this week. The euro has since come off only slightly, but is still trading above $1.3300.

Clearly there is a disconnect between the U.S. fixed-income market, CDS traders and FX markets. Currency traders have abandoned the fear of tail risk in the euro zone but have completely ignored tail risk in the U.S.

No one can ultimately predict how the budget talks will eventually be resolved but one thing is clear, the price of politics for FX markets simply isn’t priced in.

(Vincent Cignarella is a currency strategist/columnist for DJ FX Trader and co-inventor of The Wall Street Journal Dollar Index. His 30 years in currency markets include working as a bank dealer at major money-center commercial banks; managing corporate-hedging for a large multinational; serving as a principal and general partner of a major currency brokerage firm; and most recently working in FX sales with Santander in New York.)

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